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Understand How to Short the Bond Market

written by: Tim Plaehn•edited by: John Garger•updated: 3/24/2011

Short selling the bond market produces trading profits if bond prices decline. The steps for how to short the bond market require an understanding of bond prices, interest rate relationship and which securities to use to short bonds.

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    Bonds and Short Selling Concepts

    Before discussing how to short the bond market, let's first discuss what shorting is and how the bond market functions. Short selling is the trading tactic of selling a security you do not own and then buying it back at a lower price. Short selling profits from a declining security price. Short selling of stock shares is a common practice and can be accomplished through any brokerage margin account.

    Bond prices - particularly government bond prices - change based on fluctuating interest rates. Rising interest rates result in declining bond prices. Short selling bonds is an appropriate strategy when interest rates are expected to increase. Remember this fact: you want to short bonds to profit from rising interest rates. Unlike stocks, bonds cannot be readily short sold through a brokerage account. The shorting of the bond market must be done through derivative securities.

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    Short Selling Bonds with Exchange Traded Funds

    The diverse world of exchange traded funds -- ETFs -- provides the tools to short the bond market. An inverse ETF is designed to change value in the opposite direction of a tracked index or securities. When bond prices fall, inverse government bond ETFs effectively provide a short trade on bonds. These funds often have the word short in their names.

    Here is a list of inverse government bond ETFs or ETNs (Exchange Traded Notes):

    • iPath U.S. Treasury 10-Year Bear ETN, symbol DTYS
    • iPath U.S. Treasury Long Bond Bear ETN, symbol DLBS
    • iPath U.S. Treasury 2-Year Bear ETN, symbol DTUS
    • ProShares Short 20+ Year Treasury, symbol TBF

    Purchasing shares in one of these funds is equivalent to shorting specific maturity Treasury bonds.

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    Leveraged Inverse ETFs

    A step up in potential return and risk from the inverse bond ETFs are the leveraged inverse ETFs and ETNs. These funds produce two or three times the daily value change of specific government bonds.

    Here are the available inverse leveraged government bond funds:

    • ProShares UltraShort 7-10 Year Treasury, symbol PST
    • ProShares UltraShort 20+ Year Treasury, symbol TBT
    • PowerShares DB 3X Short 25+ Year Treasury Bond ETN, symbol SBND
    • Drexion Daily 10-Year Treasury Bear 3X, symbol TYO
    • Dresion Daily 30-Year Treasury Bear 3X, symbol TMV

    These leveraged inverse short Treasury bond funds should only be used for short-term trading, which is day trading or trades lasting one or two days. The Financial Industry Regulatory Authority -- FINRA -- has issued warnings against using leveraged funds as long-term holdings.

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        Putting It All Together

        U.S. Treasury building 

        Now that you know to use inverse, short, bear Treasury bond ETFs to short bond prices, memorize these rules of thumb so you buy the funds to short bonds for the correct reasons:

        • Use short bonds to profit from falling bond prices.
        • Bond prices decline when interest rates increase.
        • Inverse ETF share prices increase when bond prices decline.

        The inverse of these rules is declining interest rates equal higher bond prices and not the time to short bonds. Do your research on the different Treasury bond ETFs and select the one(s) you will trade the next time interest rates start rising.

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        References

        IndexUniverse http://www.indexuniverse.com/

        FINRA: Investor Alert on Leveraged and Inverse ETFs

        Photo Credit: Wikimedia Commons